Nonbank Servicer Regulation - Urban Institute

HOUSING FINANCE POLICY CENTER

Nonbank Servicer Regulation

New Capital and Liquidity Requirements Don't Offer Enough Loss Protection

Karan Kaul and Laurie Goodman February 2016

The role of nonbanks in servicing single-family mortgages has increased tremendously over the past five years, mostly at the expense of large depository institutions. This increase can be attributed to three factors. One, many nonbank servicers specialize in servicing troubled loans and are often able to cure delinquencies more effectively than banks can. Two, significantly higher bank capital requirements make it very expensive for depositories to own servicing assets. Three, elevated representation and warranty litigation and reputational risks on pre-crisis originations forced many lenders with legacy exposure to curtain lending significantly.

In response to both the growing presence of nonbanks in the mortgage market and the relatively thin regulation under which they operate, the government-sponsored enterprises (Fannie Mae and Freddie Mac) and Ginnie Mae have issued new capital, liquidity, and net worth requirements for servicers of their mortgages. These requirements aim to reduce counterparty risk exposure from servicers in order to ensure the continued safety and soundness of Fannie, Freddie, and Ginnie. This brief explores whether these new financial requirements offer adequate loss protection given the risks.

Our key findings are that nonbank servicers have substantial exposure to interest rate and default risk that can put enormous strain on income, cash flow, and liquidity during periods of unsettled interest rates or rising defaults; and that the newly issued capital and liquidity requirements are somewhat unsophisticated and unlikely to offer adequate protection when these risks rise. We conclude that the recent steps taken to ramp up nonbank regulation are a good starting point, but that more needs to be done to ensure the government agencies and taxpayers are adequately protected against these risks under all economic environments.

Recent Trends in Mortgage Servicing

Large banks have traditionally been the dominant player in almost all segments of the mortgage business, from origination to secondary market activities to servicing and loss mitigation. The servicing business in particular has remained a major stronghold of large, vertically integrated depository financial institutions. Vertical integration brought multiple opportunities for profit, from origination fees paid by borrowers, to gain-on-sale when selling into the secondary market, to servicing fees paid over the life of loan. Keeping servicing in house also allowed banks to retain customer relationships after loan origination, often resulting in cross-sell opportunities down the road.

According to Inside Mortgage Finance data for the largest servicers, the percentage of single-family unpaid principal balance (UPB) serviced by banks remained stable at roughly 70 percent between early 2000s and 2007, with nonbanks accounting for the remaining 30 percent (figure 1). However, as the crisis unfolded, many nonbanks either went out of business or were acquired by larger banks, resulting in a sharp uptick in bank share to 94 percent by 2010.

FIGURE 1

Bank/Nonbank Split Based on Unpaid Principal Balance Serviced, 2002?15

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

Banks/Depositories Nonbanks

13% 10% 6% 7% 30% 31% 30% 32% 33% 31%

14% 24% 29% 31%

87% 90% 94% 93% 86%

70% 69% 70% 68% 67% 69%

76% 71% 69%

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Source: Urban Institute calculations based on Inside Mortgage Finance data. Note: Shares for 2002 to 2004 are based on the top 30 servicers, shares for 2005 to 2007 are based on the top 40 servicers, and shares for 2008 onward are based on the top 50 servicers.

This increasing concentration of servicing in banks after the crisis has reversed significantly during the past few years. In 2015, the market-share split between banks and nonbanks was one again at the pre-crisis level of 70/30 percent. There are several reasons for this shift. First, large banks were heavily exposed to loans made during the run-up to the housing bubble. As defaults increased after the housing

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crisis, many of these loans were subjected to buybacks under the government-sponsored enterprises' (GSEs') and the FHA's rep and warrant indemnification policies. Faulty loans also generated a flood of litigation that many lenders ultimately settled, paying tens of billions of dollars in fines. Worried about further negative fallout from financial, litigation, and reputational risk, these lenders significantly curtailed their lending and servicing activities. In comparison, smaller nonbanks had very limited legacy loan exposure and faced lower litigation and reputational risks, putting them in a stronger position to pick up the slack.

Second, as the volume of delinquencies skyrocketed after the bubble, so did the need for servicers to allocate substantial resources to either bring loans out of delinquency or see them through expensive and time-consuming foreclosures. Servicing nonperforming loans tends to be high-touch, laborintensive, and very expensive (Goodman 2014). To minimize losses for both borrowers and investors, servicers need to reach out and invest the time to understand each borrower's financial situation, evaluate multiple loss-mitigation strategies, and find the best approach to cure the delinquency. Banks, having encountered very low delinquencies historically, didn't have much experience servicing large volumes of delinquent loans and were therefore ill-prepared for this task. Nonbanks--often smaller and less complex, with lower regulatory capital and compliance costs, very limited legacy exposure, and precrisis experience in the origination and servicing of lower-quality loans--were better situated to respond to the changing landscape.

Third, the already steep cost of servicing nonperforming loans has increased even more under the Basel III capital regime, which treats mortgage servicing rights (MSRs) highly unfavorably and doesn't apply to nonbanks. Under Basel III, which went into effect January 1, 2015, MSRs are subject to at least a 250 percent risk weight up to a certain threshold and a substantially higher risk weight thereafter. This, too, has encouraged banks to pull back from the servicing business, opening the door for nonbanks for fulfill this market need.

Current Regulation of Nonbank Financial Institutions

Though both banks and nonbanks were underregulated and undercapitalized before the crisis, the financial reforms put in place afterward have largely addressed those issues on the bank side. Nonbank regulation is one piece of unfinished business from the crisis. Traditionally, nonbanks have not been subject to the same level of supervisory financial regulation and capital requirements as depositories. Nonbanks don't hold consumer deposits and don't have a retail presence, thus limiting the potential for customer disruption in the event of insolvency. Further, disruption of servicing upon failure of a nonbank servicer is typically avoided by transferring servicing rights to a financially sound servicer,1 thus ensuring continued collection of mortgage payments from borrowers and uninterrupted remittance of principal and interest (P&I) to mortgage-backed securities (MBS) investors.

Unsurprisingly, the strong pace of growth and increased role of nonbanks since the crisis have prompted calls for greater supervision (FHFA 2014a; FSOC 2014). The growth in MSRs owned by nonbanks has been so rapid that the necessary investments in operations, such as systems and

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processes,2 have not kept up. The flood of MSR transfers from banks eager to offload servicing portfolios occurred before nonbanks were able to upgrade their systems, processes, or staff training; nonbanks often relied on a patchwork of measures that eventually led to major operational mistakes and errors. Such errors often caused significant financial harm to borrowers in unnecessary foreclosures or the inability to receive a timely loan modification. To mitigate their risk of increased exposure to nonbanks and minimize consumer harm, the GSEs and Ginnie Mae, as well as the Consumer Financial Protection Bureau, have issued new regulatory and capital requirements for mortgages servicers.3 While the GSEs' and Ginnie Mae's requirements are mostly financial--covering minimum capital, liquidity, and net worth requirements--the Consumer Financial Protection Bureau's requirements focus more on consumer protection.

Because the requirements set forth by each of these agencies mostly address the specific risks they are exposed to or responsible for regulating, comprehensive firmwide standards are lacking. In light of this, the Conference of State Bank Supervisors (CSBS)--a coalition of state regulators--has proposed state-level baseline financial and operational standards for nonbank servicers (CSBS n.d.). Collectively these capital and liquidity standards will help establish a minimum financial floor for nonbank entities considering servicing residential mortgages. Yet, CSBS's operational standards in risk management, servicing transfers, corporate governance, and data protection will, if finalized, promote better customer service and protection.

Table 1 summarizes the key financial requirements adopted by the GSEs and Ginnie Mae and those proposed by the CSBS. For comparison, this table also shows MSR treatment under Basel III. The GSEs and Ginnie Mae finalized these financial standards without releasing robust supporting analysis to justify them, leaving it unclear if the standards are adequate considering the risks involved. To determine whether they are, we must first assess how risky nonbank servicing really is.

TABLE 1

Nonbank Servicer Capital and Liquidity Requirements

Minimum net worth

Minimum capital ratio Minimum liquidity

Effective date

Fannie/Freddie seller servicers

$2.5 million plus 25 bps of servicing UPB

Net worth/total assets of 6% 3.5 bps of agency servicing UPB plus incremental 200 bps of NPL servicing over 6% agency UPB Dec. 31, 2015

Ginnie Mae issuers

$2.5 million plus 35 bps of issuer UPB Net worth/total assets of 6% Greater of $1 million or 10 bps of MBS outstanding

Jan. 1, 2015 (new issuers); Dec. 31, 2015 (prior issuers)

CSBS baseline

$2.5 million plus 25 bps of servicing UPB None

3.5 bps of all servicing UPB; no incremental charge Proposed

CSBS enhanced (complex firms)

Management and board of directors to develop methodology subject to third-party verification and regulatory approval; methodology should incorporate portfolio size, advance requirements, loan type, etc.

Proposed

Basel III MSRs (doesn't apply to nonbanks)

250% risk weight for MSRs under 10% of Tier 1 capital; dollarfor-dollar charge for MSRs over 10% of Tier 1 capital

Jan. 1, 2015

Note: bps = basis points; CSBS = Conference of State Bank Supervisors; MBS = mortgage-backed securities; MSR = mortgage servicing rights; NPL = nonperforming loans; UPB = unpaid principal balance.

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Risks Faced by Nonbank Servicers

The value of MSRs--which form a considerable portion of a nonbank balance sheet--depends on both interest rate risk and default risk. MSRs grant the owner the right to receive and retain servicing fees from borrower monthly payments.4 The value of MSRs is essentially the present value of the servicing income that a servicer expects to receive over the life of a loan, net of servicing expense. In other words, MSR values depend on two factors: annual servicing fee minus the cost of servicing the loan, and the life of the loan (years). Because the servicing fee is largely fixed at origination and the cost of servicing performing loans fairly modest, the single most important driver of MSR values for nondistressed loans tends to be the life of the loan.5 The longer a mortgage remains in active payment status--that is, the borrower neither prepays (refinances) nor defaults--the more servicing income a servicer can expect to earn, and the more valuable the MSR becomes. Thus, MSR prices depend on the default and prepayment rate each pool experiences.

The default rate on a pool of performing mortgages can be reasonably estimated using loan and borrower credit characteristics, and this estimate remains relatively stable under all but the most severe economic environments. The expected default rate therefore tends to be less of a driver of MSR values from day to day. In contrast, mortgage rates are much more difficult to predict and change daily, causing the prepayment outlook and, ultimately, MSR prices to change constantly.6 The interest rate risk inherent in MSRs is amplified by three additional factors:

inherently high volatility of MSRs complex and imperfect hedging significant nonbank balance-sheet exposure to MSRs

MSRs Are Highly Volatile

Mortgage servicing rights are very similar to interest-only (IO) securities, which are backed by the interest portion of a mortgage. The price of a typical agency mortgage-backed security, such as a passthrough, is driven by the likelihood of receiving both the principal and interest payments. When a mortgage prepays, though investors lose future interest income, the principal component of the mortgage-backed security retains its value. The price of an IO (MSR), in contrast, is driven by the likelihood of receiving just the interest payment (servicing fee). Thus, when a mortgage underlying an IO (MSR) pool prepays, the expected cash flow from that mortgage vanishes. As a result, an IO (MSR) has a steeper decline in value and greater price volatility than a traditional mortgage-backed security.

Another source of heightened volatility is that MSRs are not actively traded in an open liquid market. Instead, as level 3 assets, MSR values are significantly model dependent, giving rise to increased model risk. The thinly traded nature of MSRs also means it can take longer for new information to be priced in, often resulting in more pronounced price swings.

To illustrate MSR volatility, we compared the daily price change for 3.5 percent coupon Fannie Mae MBS to the same coupon Fannie IO from 2011 to 2015 (figure 2). The coefficient of variance7--which

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